Why the market is wrong about private equity

The collective wisdom of investors, as evidenced by share prices, is right much more often than the expert pundits. But it is far from infallible, especially when it comes to listed private-equity trusts.

The 2008-2009 financial crisis left most of the sector over-committed to additional investments without the financial resources to pay for them. Share prices crashed, leaving the trusts with the uncomfortable choice between raising new equity at rock-bottom prices or selling investments at distressed prices into a buyer’s market.

Only HgCapital Trust (LSE: HGT) had been sufficiently prudent to have clearly avoided the dilemma, resulting in outstanding subsequent performance. Candover was the worst affected and could only struggle on while its portfolio was liquidated. In between were 3i (LSE: III) and Pantheon (LSE: PIN).

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3i succumbed to pressure from its investors and brokers and launched a deeply discounted rights issue. This was widely praised but it soon transpired that it didn’t need the money.

Pantheon, under then chairman Tom Bartlam and chief executive Andrew Lebus, refused to follow suit, arguing that they could ride out the storm. The share price fell below 20p (adjusted for a subsequent ten-for-one split) but by the end of 2021 had multiplied 18-fold, well ahead of 3i’s performance.

Across the sector, investors had been too pessimistic.

History repeats itself

This year, history has been repeating itself with share prices falling even though the trusts have been reporting significant progress. Investors, it seems, simply do not believe what they are being told by management, valuers, auditors and Boards,

The share price of 3i, for example, had fallen 30% by the middle of June but, five weeks later, 3i reported a total investment return of 6.6% for the first quarter.

The largest investment, discount retailer Action, had continued to perform strongly and over 90% of the top 20 companies in the portfolio had reported higher earnings. Subsequently, one investment had been sold at a 50% uplift to its 31 March valuation. Despite economic conditions deteriorating, 3i remained confident. Yet, as Chris Brown, JP Morgan Cazenove’s analyst, noted, 3i’s shares were trading at a 13% discount to net asset value compared to a long term average of a 17% premium.

Pantheon’s share price had fallen 30% by mid July despite a total investment return of 11.5% in the first half. This prompted Investec analyst Alan Brierley to exclaim “Distress? What distress? The discount is at a level (45%) we would typically associate with a portfolio and/or balance sheet in distress. However, this distress has been conspicuous by its absence. The NAV has proved highly resilient, reaching new all-time highs, and materially outperforming public markets.”

The share price of Oakley Capital (LSE: OCI) had been more resilient, falling just 13% by late June. In late July, it announced investment returns of 17% in the first half including 11% in the second quarter, two thirds of which came from earnings growth. As elsewhere, asset disposals at a significant premium to book value gave credibility to the valuations. Yet at 30 June the shares were still trading at a 40% discount to asset value.

Even HGT, despite its exceptional record, saw its share price fall to a 32% discount. Ewan Lovett-Turner, analyst at Numis, calculated that there had been “recent valuation events (such as disposals) at uplifts to previous valuations for around 30% of the portfolio while cash accounts for another 10%.”

Chris Brown seeks to put these anomalies into context by looking at the 16 calendar quarters since 2000 in which the All Share index fell by more than 5%. He finds that the correlation of net asset values to the market is low, due to irregular valuations, but share prices are more volatile than markets. The average discount, he notes, widened on average by 10.5% in those quarters while being unchanged in the long term This meant that discounts narrowed sharply and the funds out-performed when markets were rising.

One fund’s woes could have contaminated the whole sector

The unprecedented disparity between share prices and asset values suggests an additional factor, perhaps the fiasco surrounding Chrysalis (LSE: CHRY). Issued at 100p in late 2018, its share price reached 270p in late 2021 but is now barely above the issue price, though still valued at £626m.

Chrysalis had a very different business model to the prevalent one of private equity. Rather than seeking controlling stakes, either by itself or with partners, in companies whose strategy, operations and management it could then influence, Chrysalis acquired modest, passive stakes in companies intending a stockmarket flotation without, it seems, the careful due diligence and strategic thinking of the likes of Baillie Gifford.

Moreover, Chrysalis, caught up in the prevalent euphoria, rushed into a series of technology-related concept stocks with doubtful prospects and high valuations, such as The Hut Group and Klarna. The share price of the former has fallen 90% in the last year while the latter, still unlisted, has had to raise additional funds at an 80% discount to the implied valuation of just four months earlier.

Unsurprisingly, investors are sceptical about the rest of the portfolio and their disillusion has contaminated the whole listed private equity sector.

Nevertheless, Chris Brown’s analysis suggests that returns should be exceptional as the overall market recovers for nearly all the listed funds. This recovery appears to have already started with strong returns in July, including over 10% for Harbourvest, 3i and HGT.

Funds in distress, however, should be avoided, despite tempting discounts. Buying or holding onto Candover in 2009 would have been a mistake, as would holding Patient Capital (LSE: SUPP) after it moved to Schroders. These precedents suggest that Chrysalis should still be avoided, despite its trading at an apparent 40% discount to net asset value.

In this respect, if not for the sector as a whole, the market is probably right.